China's Emerging Peak

Testing Policy. Reopening the global economy brings inflation pressures as supply chains lag accelerating demand. Certainly, cargo ships littering the port of Los Angeles signal supply chain issues, not a prolonged inflation threat. While investors rightly fret about inflation, the greater risk may lay with China’s real estate bubble. The unraveling of a credit bubble can bring a debt-deflation spiral that counters the narrative of the moment, inflation. Deflation would leave investors poorly positioned as temporary inflation distracts them from the greater threat. Regardless of the locale, investors are now beholden to the Federal Reserve’s monetary policy exit and China’s ability to deflate their debt bubble. While political scientists await the validation of capitalism or communism, investors hold their breath.

The U.S. Federal Reserve and China’s Communist Party face tests to their abilities as they withdraw their Pandemic-induced monetary policy.

Success will mitigate the inflation risks, while failure may bring a global debt-deflation spiral. The global economy hangs in the balance.

Borrowing Binge. The pending collapse of Evergrande brings concerns about the viability of the Chinese economy and a possible “Lehman” moment. Unquestionably, the debt-fueled growth since the financial crisis is remarkable for its speed (Exhibit 1). In recent memory, only Spain produced such a rapid acceleration of debt. Yet its economy is about one-tenth the size of China’s, and it does not account for roughly a fifth of the global economy. The scale difference determines whether the unraveling is a local or global phenomenon. The world awaits the response.

As Spain discovered (and Japan before it), the bursting of a debt-fueled bubble can hamper growth for a generation. The hope is that capitalism with Chinese characteristics will prevent the occurrence of a Minsky Moment. Indeed, the centralized structure of the Chinese Communist Party permits authoritative action when required. The trouble is that history is not kind to any political regime when a debt bubble bursts. A critical dimension of success in addressing a debt bubble is the capacity of the country to take the liabilities on its balance sheet. As Japan showed after its bubble burst, this willingness can avoid the immediate collapse while delivering lower future growth.

Exhibit 1. Total Debt as a Percent of GDP

Source: Bank for International Settlements, retrieved from FRED.

Consuming Debt. A defining outcome of whether the country nationalizes debt is usually a function of where the debt accumulates. Outside of government, there are only two sectors: the household or non-financial companies. Indeed, the debt explosion in China saw household debt reach a level comparable to its peers in about a decade (Exhibit 2). The speed of the ascent has no modern parallel. The closest is Spain’s bubble, yet it unfolded over two decades and started higher. While there are no precedents for the speed of China’s household debt accumulation, there is hope.

The fortunate dimension of the Chinese household debt burden is that its level is not as stretched as the U.S. or Spanish incidents. Its current level is consistent with the average developed market. The challenge is both the scale of the debt and the GDP per capita of China. Its debt would exceed the level of the G-7 countries, excluding the U.S., while possessing a per capita income that is one-sixth of the U.S. and one-third of Spain’s. Indeed, the ability to withstand a debt crisis is a function of the capacity to service the debt payments. China stands alone in this regard: no country has achieved this scale of debt at this low of an income level. Herein is where the challenge ahead resides.

Exhibit 2. Total Household Debt as a Percent of GDP

Source: Bank for International Settlements, retrieved from FRED.

Booming Credit. China’s residential property boom is well known. The driving force beyond this boom is their local governments, which are limited in their borrowing capacity. Yet, they circumvent this restraint by selling property rights to developers using off-balance-sheet financing. While direct measures of local borrowing are opaque, Evergrande can attest to the copious corporate borrowing. Between national growth targets and plentiful availability of credit lays an enormous growth in debt.

Since the financial crisis, Chinese non-financial credit jumped more than 60 percent as a proportion of GDP (Exhibit 3). The level well exceeds the peaks in Japan in the early 1990s and Spain during the Financial Crisis. This level has historically been a place where the credit boom ends. Indeed, if not for the Pandemic and the fiscal and monetary stimulus it delivered, the Chinese credit bubble may have popped. Instead, corporate and government borrowing ramped up to fight the ravaging effects of the Pandemic and postpone the credit comeuppance for another day. The impact of this increased credit may make the reckoning more difficult in the future as the capacity of the national government becomes more limited.

Exhibit 3. Total Private Non-Financial Debt as a Percent of GDP

Source: Bank for International Settlements, retrieved from FRED.

Future Investment. A hallmark of Keynesian economics is government expenditures during times of anemic demand, like those that can occur during the bursting of a credit bubble. China’s challenge lies in its prior investment, which accounts for 40 percent of the global total. It is one thing to update dilapidated bridges and highways, which the U.S. seeks to do with its current Build Back Better bill meandering through Congress. Building more excess capacity when bridges to nowhere and empty apartment buildings already exist is another thing.

In an environment that followed Keynes' advice to dig holes and fill them in, it's not evident that borrowing to do more of the same is additive. Yet, it may be China’s only choice as the political legitimacy of the communist party hinges on continued growth. Failure to deliver further growth could incite domestic turmoil. A debt deflation spiral after a generation of development could ignite a revolution. They are aware of these possible outcomes. Their challenge is to keep the music playing while not ending up in Japan’s situation of continual debt expansion. As their tech titans recently discovered, now is a perilous time to be a capitalist in China, as they are the most likely target of any rebalancing.

Exhibit 4. Chinese Fixed Investment (as a percent of the World)

Source: OECD. World is OECD and China combined. Annual data through 2019. CRM Calculations.

Braking Downhill. A further challenge for China is that the demographic tailwind they enjoyed for five decades is now a headwind (Exhibit 5). A young, dynamic workforce is easier to cajole into a nationalist fever as their youth naturally aspires to greatness. Yet, the working-age population for China is now in terminal decline. The investment boom and debt surge that rode along with it amplifies this situation because the marginal product of increased investment is limited. China's growth prospects appear limited without the demographic dividend to lift growth as a matter of course or the ability to borrow from the future. Yet, the situation is not terminal.

Growth is as much a function of productivity as it is of population. The ability to do more with less is the defining characteristic of the past two hundred years of civilization. While China faces the same demographic fate as Japan, with a declining workforce and a large population of retirees, its demise may have to wait for the next decade. As the world undergoes profound technological change, a segment of the population is more amenable to it and better able to leverage its productivity-enhancing benefits. This group is where there is hope for China and the world to avoid a debt-deflation spiral.

Exhibit 5. China’s Workforce Population (Ages 20-65 Years)

Source: U.N. Population Division. CRM Calculations.

Peak Productivity. The confluence of youth and experience is the primary driver of productivity. While most young people enter the workforce thinking they know everything there is to know; most are not proficient until after more than a decade of learning the ropes. Critically, the proportion of 35-50 years old to 20-24 years old in the workforce is a critical determinant of productivity. The latter group, the Learners, bring enthusiasm yet lack experience. The former group, the Producers, brings expertise and adaptability as they strive to excel in their careers. Herein lays China’s saving grace.

The Producers cohort will expand in China for the next decade (Exhibit 6). This group should continue to increase productivity and offset some of the declining growth from their shrinking workforce. Japan faced a similar fate in the 1990s and was able to postpone their demographic reckoning. China can follow a similar path and alleviate the corporate debt burden by moving it onto their balance sheet. This action would permit the confluence of demography and technology to deliver growth to ease the debt burden. The choices for the global economy are stark: a worldwide debt liquidation that brings deflation or slower growth with modest inflation. Best plan ahead.

Exhibit 6. China’s Productivity Peak (Population of Producers/Learners)

Source: U.N. Population Division. CRM Calculations. Population ratio of Producers (35-49 years old) to Learners (20-34 years old). A higher ratio reflects higher potential productivity.

This article is the Macro View in our Global Portfolio Strategy for the third quarter of 2021. Read more here.

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